Awareness around factors that lead to bad decisions can help investors remain cool when markets heat up.
As we move into summer, we are starting to experience some very hot days. Anecdotally, everyone knows that we all get a little more cranky in the heat — but there has been much research on the topic. In fact, one study in the USA on the impacts of hot temperatures on road rage showed a direct correlation.
It must have been a fun study to do. The research team purposely irritated drivers by remaining stopped at green traffic lights and then measured how many people honked their horn and shouted abuse on days with varying temperatures. They also measured the difference between cars with windows down (the assumption being that air-conditioning was not being used), and up. It must have almost been like Candid Camera.
Called ‘heat hypothesis’, there is statistically a direct link between hotter days and greater ‘behavioural errors’. Another study in Spain showed an increase in road accidents of 7.7% on days of extreme heat. There is also a correlation to murders, assaults and car thefts.
Awareness of additional risks is the clear antidote to being susceptible.
Poor decisions often come from a poor decision-making environment
Lead researchers discovered that the real cause of the increased road rage and violence is that heat causes discomfort. When uncomfortable or out of the comfort zone, human beings become irritated and emotions are heightened. This often means the survival instinct kicks in and threats are exaggerated.
Money is similar to heat — it exacerbates and exaggerates emotions
With the markets and asset prices becoming more volatile, but no consistency of themes occurring, we are seeing more and more behavioural errors occurring. The environment within which investment decisions are being made is becoming less conducive to good decisions, and a number of common behavioural errors are the result.
Myopic loss aversion: Investors experience emotions of losses twice as significantly as those of gains. As a result, when prices become more volatile investors become too strongly focused on short-term losses and exaggerate their impact. Together with recency bias (where investors assume the recent past will persist in the long-term future), this emotion often leads to the error of making rash short-term decisions which have a long-term cost
The antidote is to reframe the short-term losses. For example, by looking at the frequency of previous similar losses and the subsequent recovery, as well as refreshing the principles on which market returns are based.
Mental accounting: In their heightened emotional state, investors evaluate their investments separately rather than as a portfolio. They look at each investment in a time-specific way, expecting each to be doing well all the time. The emotions of mental accounting, when combined with loss aversion, result in investors holding onto losers and selling winners.
The antidote is to focus on the returns of the portfolio rather than individual returns, and on the quality and diversification of the underlying assets.
The halo effect: The uncertainty of a volatile market leads investors to seek out a ‘hero’. At the same time, ‘experts’ expound their theories in the media, which together with the local grapevine, leads investors to look for the silver bullet. The impact of this effect can be seen when companies with familiar names trade at higher valuations than companies or ticker symbols that are more difficult to remember. The likeability of a CEO has a similar impact, as does the endorsement of a well-known investor. As I often say to our clients, “trust the process, not the people”.
Volatility doesn’t mean long-term outcomes should be poor
The past 10 years has been a particularly benign and fruitful period for investing. Volatility has been lower than average and returns higher. On a relative basis, it is unlikely to be as good over the next 10 but this does not mean that the final outcomes should be any worse.
The greatest contributor to investment returns is investor behaviour, and the greatest contributor to quality decision-making is awareness. As we go into a hot summer and more volatile prices, those that have the awareness that hotter days lead to hotter emotions — and therefore greater risk — will be less likely to make bad decisions.